It's worse than investors expected and worse than management expected in July. Those are the two primary conclusions from RTX's (RTX -0.29%) recent presentation on its Pratt & Whitney GTF engine fleet update. Is it safe to conclude that the stock is to be avoided, or is this a buying opportunity? Here's the lowdown.
What management said in July
Now, I know you want to get to the update quickly, and you'll find that below if you are in a hurry. Still, here's a quick primer for investors unfamiliar with the issue and those who like to monitor the cadence of management's commentary.
I previously discussed why September was a critical month for investors in the company formerly known as Raytheon Technologies. Back in July, on the second-quarter earnings call, management had promised an update on the longer-term financial impact of its inspection of in-service GTF engines manufactured between the fourth quarter of 2015 and the third quarter of 2021. As a reminder, the GTF is one of the two engine options on the Airbus A320 neo airplane -- the other option is an engine from General Electric's joint venture, CFM International.
After discovering a potentially rare condition in powdered metal used on turbine discs on the engine, management decided to remove an initial 200 GTF engines for inspection by the middle of September. It also estimated that a further 1,000 engines would need to be inspected between 2023 and 2024. Consequently, management lowered its full-year 2023 free-cash-flow (FCF) guidance by $500 million to account for the hit in 2023.
On the earnings call in June, Morgan Stanley analyst Kristine Liwag asked whether the issue would impact the company's outlook for $9 billion in FCF in 2025. It's an important figure because investors are penciling it into valuations. CFO Neil Mitchill replied, "I think it's too early to put a number on that." However, CEO Greg Hayes told investors, "We've got two years to work through that, and we will figure that out, but in terms of the cash, really probably not a big difference as you get out to 2025."
What management says now
Unfortunately, Hayes' commentary in July proved too optimistic. The inspections won't be over in two years, and there will be a big difference in terms of cash in 2025. The only possible positive is that there will be fewer inspections than originally planned. The key highlights:
- About 600 to 700 incremental "shop visits" (engines are sent for overhaul and maintenance) required from 2023 to 2026
- A "majority of incremental engine removals will occur in 2023 and early 2024," according to the company.
- An average of 350 aircraft on the ground from 2024 to 2026, with a peak in the first half of 2024
- A $3 billion cash headwind between 2023 and 2025, with a $1.5 billion hit in 2025, leading to a reduced expectation for $7.5 billion in FCF in 2025
What it means for investors
The problem is worse than initially expected in July, and the lowering of 2025 FCF expectations is a negative. Based on the market cap at the time of writing of about $112, hitting $7.5 billion in FCF would put the company on a price-to-FCF multiple of slightly less than 15 times FCF in 2025. That looks like a good value because the company has many medium- and long-term earnings drivers.
There's lucrative long-term recurring revenue from the aftermarket for aircraft engines. There's an ongoing recovery in airplane production and demand for airplane parts. Meanwhile, on the defense-focused side of the business, easing supply chain and labor issues should lead to margin expansion as the company delivers on its growing defense backlog.
That said, it's never good news when management underestimates the enormity of a significant issue, and there's obviously scope for further deterioration as the engines are inspected.
Image source: Getty Images.
Is RTX stock a buy?
Unfortunately, the latest update is not good news, and there won't be a quick fix to the problem. Moreover, the GTF may lose some market share to the CFM engine option. Investors looking for aerospace and/or defense exposure can probably find better ways to invest while they wait for more clarity on the issue.
On a more positive note, management noted that the "majority" of the "incremental engine removals" will occur in 2023 and early 2024. Consequently, investors will have a good read on the definitive financial impact in that time frame. Until then, the issue is likely to hang over the stock.
